Did Bear Stearns Know Its Mortgage Securities Were a House of Cards?

This week, a lawsuit filed against Bank of America detailed the worst mortgage practices at Countrywide -- which BofA acquired in 2008. The suit charged that Countrywide had, as a policy, disregarded borrowers' ability to repay their loans because fraudulently securitizing the mortgages was the bank's sole purpose in making them. But Bank of America (BAC) isn't the only major financial institution now facing a legal battle over the past behavior of a company acquired during the financial meltdown.

A lawsuit filed by Wells Fargo against JPMorgan Chase (JPM) unit EMC Mortgage Corp. last week should force Chase to reveal if the conduct of the bank it purchased -- Bear Stearns -- was as bad as or worse than Countrywide's, as another lawsuit alleges. Based on the filings, Bear and its EMC subsidiary behaved remarkably like Countrywide, ignoring the quality of loans in order to create an ever-larger quantity of toxic mortgaged-backed securities.

Wells Fargo (WFC) is the trustee for a trust that issued mortgaged-backed securities built from loans it bought from EMC. That give Wells the right to look at the documents for each of the 2,049 mortgages backing the securities. But after a year of requests to see the loan files, EMC has yet to turn over a single one, which begs the question: Does EMC have something to hide?

Show Us the Documents

A lawyer for a major investor in the securities has already looked at about 1,300 of the 2,049 mortgages, and found 938 of them appeared to violate the representations and warranties made about them. In other words, the mortgages were worse than promised. If that's the case, Wells should be able to force EMC to buy them back -- hence, its requests, and now its lawsuit, demanding to review the files.

How could it be that 70% of the mortgages reviewed so far allegedly violate the securitization contracts' promises regarding mortgage loan quality? An earlier lawsuit filed by securities insurer Ambac (ABK) gives some insight into that question. According to that suit, and the myriad documents it cites in support, EMC/Bear knowingly purchased risky loans made to borrowers who couldn't repay them and packaged those loans into securities while lying about their quality.

Here are some of the highlights of Ambac's charges.

Bear Stearns Knew Loans Didn't Pass Muster

Ambac charges that Bear knew the loans were bad, pointing out that Bear knowingly hired inept firms to review and monitor loan quality. Then, when the "due diligence" companies did flag loans as bad, Bear overrode their decisions more than half of the time. Still worse, the suit says:

Bear Stearns ignored the proposals made by the head of its due diligence department in May 2005 to track the override decisions and instead took the opposite tack, adopting an internal policy that directed its due diligence managers to delete the communications with its due diligence firms leading to its final loan purchase decisions, thereby eliminating the audit trail.

Note that this isn't just a bare allegation by Ambac. Its complaint includes a footnote explaining that this information comes from two sworn depositions.

The suit also notes that by 2007 Bear still hadn't implemented a due-diligence overhaul designed to improve loan quality that was first proposed in 2005. In fact, it moved in the other direction. The suit explains, Bear "issued a directive in early 2005 to reduce the due diligence 'in order to make us more competitive on bids with larger sub-prime sellers.'"

One telling sign, according to the suit, that Bear knew how bad the loans were: Without telling investors or bond insurers like Ambac, Bear deviated from its policies on holding onto loans before selling them. Depending on the deal or underlying loan type, Bear had a policy of holding onto the loans for a period ranging from 30 to 90 days. But once it realized how poor the loans were, it kept the policy in place on paper but violated it routinely by securitizing them earlier.

Loans So Bad Bear Didn't Want to Know

In fact, the suit claims Bear would not only securitize those loans but would also go after the companies that sold the loans to Bear in the first place, settling with them in secret. Bear apparently had two departments dedicated to getting paid back for the bad loans, despite the fact that it had already securitized them. And the volume of bad loans grew so much that the departments became overwhelmed. "By mid-2006," the suit notes, "Bear Stearns' repurchase claims against the suppliers had risen to alarming levels, prompting warnings from its external auditors and counsel" that Bear was breaching its contracts.

Indeed, the deal manager for one 2006 securitization was clear about the incredibly poor quality of the underlying loans, referring to the deal when emailing Bear's trading desk as a "shit breather" and "a SACK OF SHIT."

Things got so bad that in 2007 Bear stopped wanting to know about loan quality, the suit says. Citing a deposition, Ambac charges that Bear told its employees to simply stop reviewing certain loan files and just securitize them. And not just any loan flies -- the instruction to stop reviewing applied specifically to mortgages Bear had already purchased from lenders whose standards were so poor that Bear wouldn't buy any more from them.

You read that right: Bear knew some lenders were making such risky mortgages that it would no longer buy from them, but rather than risk getting stuck holding the loans it had already bought from them, it securitized those loans while purposely not reviewing their quality -- or so the evidence cited by the lawsuit says.
Threatening Ratings Agencies

The lawsuit also makes charges regarding Bear's efforts to keep the crappy quality of the loans hidden. One claim is that in 2007, the company threatened the ratings agencies that were downgrading Bear's mortgage-backed securities, saying it would withhold "every fee" owed to the agencies because of downgrades. Ambac also provides details of how Bear finally started reviewing its files and found that many of the mortgages in its securities violated the promised quality standards -- but didn't tell anyone about it.

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When Ambac was able to review 695 loan files across several deals it insured, it discovered that 80% of the loans were bad. (To date, the suit later notes, Ambac has reviewed 6,309 loans and found that 5,724 of them violated one or more of Bear's promises about loan quality: an even worse 91% rate.)

Bear rejected Ambac's requests that it repurchase the bad loans and instead implemented a trading strategy of betting against Ambac. Think about that. According to Ambac, Bear knowingly securitized bad loans, conned Ambac into insuring the deals, refused to buy back the bad loans when Ambac discovered them, and then bet against Ambac's survival. Pretty cold.

Ambac contends JPMorgan Chase kept up these tactics of concealing bad loans and refusing to buy back ones that were discovered in order to keep its balance sheet pretty, saying JP Morgan "effectively engaged in accounting fraud."

All About Executive Pay?

Why did Bear deliberately purchase and securitize such horrible loans according to the complaint? Because its executives' pay depended on it. The securitization machine was led by 10 executives -- also defendants in the suit -- the top four of whom made a combined $1 billion in the years preceding Bear's 2008 collapse.

The 162-page complaint goes into great detail about the particular lies Bear and then JPMorgan allegedly told, and how investors -- and Ambac, as the insurer -- have been hurt by them. Reading the filing clearly illuminates how much of a threat to the big banks their mortgage-backed securities may be.

It also underscores exactly why EMC is apparently stonewalling Wells Fargo's efforts to look at its loan files. I can't wait to see how EMC responds to the Wells Fargo suit.